When it comes time to construct portfolios, many investors overlook the potential benefits of  listed options. While there could be many reasons that insufficient attention is paid to options,  I believe that the main culprit  is widespread misunderstanding of the nature and role of options in general, and specifically their potential to reduce the risk and enhance the returns of underlying equity holdings. With that in mind, let's take a closer look at some of the myths surrounding options.

Common Options Myths

Myth #1: Options are exotic and complicated and  have no place in the portfolio of the average investor.

Like most myths, this one has an element of truth. Option strategies can become very complicated, with an almost limitless array of potential spreads and structures available. However, just because they can be complex does not mean that they have to be. The fact is that there are a variety of simple and straightforward options strategies available to any investor and the basics of options are easy to understand. A call option gives the purchaser the right to "call" the stock to them (i.e., to purchase the stock underlying the option) at a set price (the "strike price"), within a specified period of time (the "expiration"), regardless of where the underlying stock is actually trading at that time. A put option is similar, except that instead of the right to buy the stock, the option purchaser has the right to "put" (i.e. sell) the stock to the option "writer" (i.e. the seller of the put). For a more detailed explanation of options, click here to read our "Gargoyle Group Equity Options Primer."

Myth #2: Options are very risky and by their nature expose investors to large losses.

Again, while an investor can certainly choose a strategy  that takes on a large amount of risk, the availability of risk does not make all option strategies risky in and of themselves. In fact, when purchasing options, the investor's risk is always limited to the premium amount paid for the options. Although selling options "naked" (i.e., without a position in the underlying stock to cover the options) can expose an investor to large losses, selling covered options can actually reduce the risk of the position. Like any investment, the key is to structure and size the trade appropriately so as to control the risk to the overall portfolio. At Gargoyle, our focus is on the use of options to manage, control and reduce risk in underlying stock portfolios.

Myth #3: Options are used primarily for speculation.

Options are leveraged instruments - each standard option contract represents control over 100 shares of the underlying stock.  It is possible, therefore, to use options to make a highly leveraged, speculative bet on the price movement of a stock or index. However, this is by no means the primary function of options. In fact, it is far more common for investors to purchase downside puts as "insurance" for their stock portfolios (thereby reducing their downside risk), or to sell out-of-the-money covered calls against stock they already own, exchanging some upside potential for the income collected by selling option premium.

Put Options as a Hedging Instrument

As mentioned above, options are commonly used to hedge either single-stock holdings or entire stock portfolios.  One way to do this is to buy a downside put on a stock or index, thereby acquiring the right to sell that stock or index at a predetermined price.  This is very similar to purchasing insurance. For a price (the option premium), the investor transfers the risk of a large loss to the option seller (similar to the insurance underwriter).  Like any insurance, this strategy comes with a cost.  Just as insurance companies need to charge more in premiums than they expect to pay out in losses, option sellers need to collect more in excess premium than they expect to pay out in adverse events in the stock market. The result is that index options tend to be overpriced. Therefore, while buying puts will reduce an investor's downside risk, they will also reduce returns - sometimes substantially.

Covered Calls

An alternative to buying puts and paying options premium is selling out-of-the-money calls and collecting option premium. For example, an investor who owns 100 shares of Exxon-Mobil (XOM) trading at $96 could sell an XOM call option with a strike price of $100. If XOM is trading below $100 at expiration, the option expires worthless and the investor pockets the premium initially collected. If XOM is trading above $100 at expiration, the stock will be "called" away, but the investor still participates in the first $4 of upside, and still collects the option premium. If XOM declines below $96, the option premium initially collected absorbs the first part of the loss. As a result, the sale of the XOM call option partially hedges the investor's downside risk, while maintaining a degree of upside participation. The strategy is not without its drawbacks. Significantly, an investor could miss out on a large upside move (as the stock gets "called" away), and there could be adverse tax consequences in the form of realizing gains on a stock an investor has held that is sold via the exercise of the call option. Also, overpricing in single-stock options has not been demonstrated to nearly the degree that it has in index options.

Index Calls - A Hedge With an Edge

At Gargoyle, we have extensive experience in a wide range of options strategies, and we have been using a variation of the covered call strategy to hedge stock portfolios for 15 years. Instead of selling calls on the individual stocks in our portfolio, we treat the whole portfolio as an underlying asset and sell calls on a basket of indexes that have been shown to be highly correlated with that portfolio. This has the benefit of preserving stock-selection alpha since the individual stocks cannot be "called" away.  After all, we believe the stocks we select will have above average returns.  Even so, all portfolios have winners and losers. Thus if we were to sell individual stock options on all of our positions, we would be short-circuiting the upside potential of the big winners. Selling index calls avoids this problem and its potential negative tax consequences and reduces the overall market exposure of our portfolio (we generally target a 50% net long market exposure). Best of all, due to the overpricing of index options, hedging with index options gives our clients an "edge", as we collect rather than pay excess premium. We also continuously monitor and adjust the options hedge as necessary to maintain consistent market exposure intra-month.

The result has been a hedge that has both increased returns and reduced volatility over the long-term, as demonstrated by the 15-year track record of our Gargoyle Hedged Value Fund. To discuss further the role of index options and how they can benefit your portfolio, please feel free to contact me at [email protected].